Leverage denotes any technique aiming at increasing the size of assets under control, either directly (i.e., buying more assets) or indirectly (buying financial assets that ensure a partial participation in the underlying asset’s price development), without increasing the initial amount of the capital invested.

In other words, leverage is any financial mechanism used to increase the potential return per unit of amount invested, by magnifying the risk exposure at the same time.

Leverage comes in three main forms. Traditionally, leverage is understood as the use of borrowed funds to increase the size of assets under control. Beyond traditional leverage, economic leverage is also widely used. Economic leverage denotes the inclusion of assets with internal leverage in the portfolio (instrument leverage).

Since these assets are notionally funded, it is possible to control a larger amount of the underlying position with a small initial investment/ margin. Beyond these, using a third form of leverage, which is referred to as “construction leverage,” is also observable.

This term refers to the practice of combining certain long and short positions of assets with preferably high correlation, thus eliminating market risk (at least in part). By using this methodology, fund managers are targeting idiosyncratic risk with a relatively small initial investment.

Measuring the degree of leverage is not an easy task. As for the traditional form of leverage, it measures the ratio between interest bearing debt and equity within the balance sheet.

The effect of paying fixed debt costs will magnify the volatility of the (after-tax) earnings per unit of capital invested—this is also known as leverage effect. Certainly, the use of borrowed funds is, as a rule, efi cient if the gains are higher than the fixed costs of borrowing.

As for economic and construction leverage, the degree of leverage characterizes the ratio between the size off(or investment in) the initial position and the total value of the underlying controlled through this position.

The leverage effect denotes in this case that, when investing in such assets, changes in the market value of the underlying position might lead to disproportional changes in the value of the derivative position.

Note that leverage generates return distributions with inherent non-normality. This is so since by using leverage the underlying return distribution will be capped and part of this risk is transferred to other market participants (debt holders, option writers, etc.), thus creating an option-like characteristic in every case.


Leveraged Buyouts

A leveraged buyout (LBO), also known as a highly leveraged transaction (HLT), is a financial transaction where a firm’s assets are acquired using a high level of debt. This results in a very high leverage for the firm after the transaction.

Using a sample of 76 management buyout (MBO) transactions— a special case of an LBO undertaken by a firm’s management—Kaplan (1989) reports that the book value of debt to equity ratio increased from 21% before the buyout to 86% after the transaction.

LBOs along with venture capital investments are the two primary investment vehicles for private equity funds. Using a sample of 746 private equity funds that are largely liquidated, Kaplan and Schoar (2005) report that about 41% of the private equity capital was invested in these funds. The mean size of an LBO fund in their sample is about U.S. $416 million.

To compare the performance of the LBO funds, the authors discount the cashflows for these funds with the return on S&P 500 index. Net of fees and on equal-weighted basis, the median LBO fund underperformed S&P 500 by a factor of 0.80 while the fund at the 75th percentile outperformed the index by a factor of 1.13.

On value-weighted basis, where value is proxied by the amount of capital committed to the fund, the respective performance numbers are 0.83 and 1.03. They also find evidence of persistent performance.

Given LBO specialists such as KKR closely monitor a portfolio of firms after these transactions, LBOs should be thought of as a new form of organization similar in structure to that of a diversified conglomerate, according to Jensen (1989).

Kaplan (1991), however, argues that LBOs are neither permanent nor short-lived organization form. this conclusion is based on his observation that the median firm in a sample of 183 large LBO transactions between 1979 and 1986 remained private for 6.8 years after the transaction.

But why do LBOs exist? theoretically, in a Modigliani–Miller (1958) ideal world where taxes, transaction cost, and agency problems do not exist, capital structure is irrelevant and LBOs do not add any value. In reality, however, the tax shield of debt is valuable to a firm’s equity holders.

Hence, LBOs are expected to increase firm value. A counterargument is presented in Miller (1977) where an investor holds both debt and equity, and any benefit from the tax deduction for the equity gets completely offset by the tax paid on the interest income from the debt.

Empirically, Kaplan (1989) provides evidence that value of the tax shield in a sample of MBOs between 1979 and 1985 ranged from 21 to 143% of the premium paid to pre-buyout shareholders.

A second source of value in an LBO may come from the reduced agency problem of the free cashflow. Free cashflow is the cash flow in excess of what is required to finance all the positive NPV project opportunities for a firm.

Jensen and Meckling (1976) suggest that agency problem arises when a firm’s manager is not a 100% owner of the equity, he/she has incentives to invest in negative NPV projects, including consumption of excessive perks. This happens because the manager accrues 100% of the benefit from such wasteful expenditures but bears less than 100% of the cost.

Jensen (1986) argues that LBOs can mitigate the agency problem of free cashflow. Increasing a firm’s leverage increases managerial equity ownership. This assumes that the manager does not sell his/her equity interest at the LBO.

This provides the manager with powerful incentives to improve the operating performance of the firm and reduce investments in negative NPV projects.

In addition, with the interest payment of debt hanging over the manager’s head as a sword and close monitoring by the buyout specialist, he/she becomes disciplined and does not have the opportunity to waste resources.

A third source of value in LBOs could be from the strategic sale of a firm’s underperforming asset after the transaction. Strategic buyers can use these assets more efi ciently and hence may be willing to pay a premium.

Kaplan (1991) documents that about one-third of a firm’s assets are sold to strategic buyers following an LBO and argues that this is much lower compared to 72% of the asset sale in case of a hostile takeover.

A third source of value in LBOs could be from the strategic sale of a firm’s underperforming asset after the transaction. Strategic buyers can use these assets more efficiently and hence may be willing to pay a premium.

Kaplan (1991) documents that about one-third of a firm’s assets are sold to strategic buyers following an LBO and argues that this is much lower compared to 72% of the asset sale in case of a hostile takeover.

Critiques of LBOs may argue that such transactions transfer wealth from a firm’s employees to its equity holders. Improved operating performance may come from the reduced wages and benefits of the employees who have little equity ownership and hence stand to gain little from such transactions.

Based on empirical evidence, Kaplan (1989) concludes that the gain from the buyouts comes from better alignment of managerial incentive to those of the shareholders and from the reduced agency cost rather than wealth transfer from the employees.

Another critique against LBOs may be that such transactions transfer wealth from pre-LBO debt holders to equity holders. Increasing leverage also increases the probability of a bankruptcy.

As the new debt used to finance an LBO is often senior to the preexisting debt, original bondholders are likely to recover less in case of a bankruptcy.

Thus the original bondholders bear most of the increased cost of financial distress brought on by the LBO but almost none of its gains such as the benefit of the tax shield or the reduced agency cost.

LBOs may also create an asset substitution problem where a firm has to forego positive NPV projects because it is unable to finance those projects due to a high level of debt.

The evidence is mixed on whether a firm’s cost of financial distress increases after an LBO. Andrade and Kaplan (1998) examine 31 LBOs that became financially distressed subsequent to the transaction.

They provide evidence that although some firms are forced to reduce capital expenditure and a few engage in asset fire sale, these firms still had superior operating performance than the median firm in the industry.

In addition, they argue that the leveraged transaction generated a positive, albeit small, value even after subtracting the cost of financial distress. They did not find any evidence of asset substitution in their sample.

In contrast to these results, Zingales (1998) finds that highly leveraged firms have lower ability to make capital investments. Using data from trucking industry he finds that this was particularly pronounced in firms that were eventually forced to exit the industry.

Following a buyout, a firm may also face predatory threat from its deeper pocket competitors that do not have a high level of debt or interest payment. In the same study, Zingales analyzes the effect of high leverage on a firm’s ability to react to and survive competitive pressures in the product market following deregulation.

The author found that transportation firms with high leverage were forced to charge lower prices during the price war. In the end, the more efficient firms with superior operating performance were forced to exit partly due to high leverage, leaving the playing field for their inefficient, underleveraged, and deep pocket competitors.

Leveraged Buyouts
Leveraged Buyouts

Licensed Warehouse

A licensed warehouse is a warehouse approved by an exchange from which a commodity may be delivered under a futures contract. A regular warehouse must satisfy exchange requirements for financing, facilities, capacity, and location and has been approved as acceptable for delivery of commodities against futures contracts.

Indeed, exchange-traded commodities, such as energy commodities, are traded in specific lots of specific quality for specific delivery and usually also trade in forward, futures, and options contracts.

The warehouse must verify that the products delivered in their walls are conforming to the contract specifications. Furthermore, only 2% of the transacted commodity futures contracts give way to delivery.

Investors, generally, close their contracts before expiration so that they do not have to take delivery of enormous quantities of commodities for which they have no storing space and no need. Therefore, as the delivery date nears, most investors close out their positions by undertaking an equal and opposite trade.

A warehouse operator cannot issue a warehouse receipt unless that person holds a warehouse license issued by an accredited organism. All delivery of commodities must be inspected and graded to comply with the exchange specifications, stored at a licensed warehouse, and fully insured against loss from fire, windstorm, and explosion.

Licensed Warehouse
Licensed Warehouse

Life of Contract

Unlike stocks, futures contracts have limited lives. The life of contract refers to the period of those limited lives. It is typically used as an adjective, as in “life-of-contract high” or “life-of-contract low,” meaning the highest price or lowest price at which the contract traded since it was listed.

For example, the June 2008 live cattle futures contract was listed for trading on January 2, 2007 and its last day of trading (or maturity date or expiry date or expiration date—all terms for the same thing) was June 30, 2008. The life of contract for June 2008 live cattle futures refers to the 18-month period of time between those two dates.

If on July 1, 2008 an analyst said the life-of-contract high was $105.50, it would refer to the highest price during the 18-month period. But if someone mentions a life-of-contract high or low while the contract is still trading, then it means for the period from contract listing only up until that date.

Depending on the underlying asset, there are significant differences in the lives of contracts. For example, each Japanese yen contract is listed for 18 months, while each S&P 500 contract is listed for 24 months. At the other extreme are contracts such as eurodollars and crude oil.

Eurodollars typically has a 10-year life of contract while crude oil can be as much as 8 years. These differences are driven by differences in the demand for trading in the specific contracts.

For example, in the case of eurodollars, because swap dealers are entering into OTC swap contracts with institutions that go out for 10 years and since they need to often hedge the risk associated with these contracts, they need instruments that go out for a similar period of time.

In the case of stock indexes, on the other hand, even if an individual needs protection or exposure for a longer period of time the historical tendency is to take advantage of good liquidity in the nearby months and if, by the time the front month contract expires, the trader still needs exposure or protection, then the trader engages in what is referred to as a roll.

A roll involves moving one’s position to a more distant month by of setting the position in the nearby month and simultaneously establishing a new position in the more distant month.

the context in which life of contract is typically used is when referring to price statistics, like high and low. Traders are interested in the high and low prices during the previous trading day, possibly during the previous week or month, and certainly during the life of contract.

In addition, when one is analyzing futures data for different purposes, especially when one is engaging in technical analysis, a decision must be made about whether to look at the life of contract data, which is of course limited to the length of the life of that contract, or continuous (or continuation) data.

Continuous data is created by splicing together the prices for the nearby contracts during their last few months of life, but stopping usually a few weeks before the contracts expire. Stringing nearby prices together allows you to analyze many years of prices.

Life of Contract
Life of Contract

Lookback Straddle (An Example)

Let us consider a lookback call option. During the lookback period the highest price of underlying asset is Smax, and the price at present is St , then the payof of this lookback call option is
Payoffcall = Smax - St
Similarly, for the lookback put option, the payof depends on the minimum price in the lookback period:
Payoffput = Smin - St
Since the lookback straddle is the kind of construction of the lookback call and lookback put options, this strategy is benefited by taking the difference of the highest and the lowest prices of underlying assets:
Payofflookback straddle = Smax - Smin

Naked Options

A naked option is an option that is written by the option seller with no underlying asset position in the portfolio to cover its risk exposure. This means that the option seller is purely speculating on the option, assuming a very risky position. Hence, naked options are also called uncovered options, as the seller has no underlying position to cover it.

As the underlying asset starts rising call options follow the move. And, as the underlying asset has no theoretical limit to stop, the liability associated with the short call option position has no theoretical limit too. Therefore, a seller of a call option that has no underlying asset protecting the position has no theoretical loss limit.

The same effect happens for put options, considering deep market falls. When shorting naked puts, investors assume a potential downside risk without any position to sustain the losses. As the market starts falling, the put option position starts incurring losses.

Selling naked options is a very risky strategy that can be assumed in the options’ market. Sometimes it is difficult to stop losses on naked positions, especially when the series where the seller has a position is far from-the-money (deep in-the-money or deep out-of-the-money).

These series are usually very illiquid and it is sometimes difficult to close out an open positions. In these circumstances, it is advised to “close” the position using a different exercise price, creating a spread position instead.

Naked Options
Naked Options

National Futures Association

Regulatory relationship
Regulatory relationship

The Commodity Futures Trading Commission (CFTC) was created in conjunction with the Commodity Exchange Act of 1974 to regulate the U.S. futures markets (see Fung and Hsieh, 1999, for an evolutionary history of the legal environment of hedge funds).

The CFTC is an independent federal regulatory authority with the legal responsibility to ensure that futures trading serves a valuable economic purpose, to guarantee the integrity of the market and the clearing process, and to protect the interests of futures market participants from market manipulation, misuse, and fraud. The CFTC is represented at the largest futures exchanges: Washington, DC (its headquarters); New York; Chicago; and Kansas City.

The futures industry attempts to regulate itself through an industrywide selfregulatory organization called the National Futures Association (NFA), which was formed in 1982 to establish and enforce standards of professional conduct. This organization works in conjunction with the CFTC to protect the interests of futures traders as well as those of the industry.

Every company or individual who carries out futures or options trading with the public is required to register with the CFTC and become a member of the NFA. Th e NFA’s objective is to offer new regulatory programs and services making sure of futures industry integrity and to help its members in attaining their regulatory responsibilities.

In order to ensure regular trading activity, the NFA conducts background checks on applicants, conducts exams and tests, ensures compliance regulations are met, and can impose sanctions on members if necessary.

The NFA’s activities are overseen by the CFTC, on whose behalf the registration process is performed. NFA members fall into four categories:
  1. commodity trading advisors (CTAs),
  2. commodity pool operators (CPOs),
  3. futures commission merchants (FCMs), and
  4. introducing brokers (IB).
FCMs who are members of an exchange are subject not only to CFTC and NFA regulations, but also to the regulations of the exchanges and clearing organizations they belong to. Therefore, the exchange and clearing corporation personnel are under the CFTC supervision and are accountable for scrutinizing the business conduct and assuming financial responsibility for their member firms, floor brokers, and traders.

Violating exchange rules can have serious consequences resulting in heavy fines, suspension, revocation of trading privileges, and even the loss of exchange or clearing corporation membership. Even though the different regulatory organizations in the futures industry have their own particular areas of authority, jointly they form a regulatory partnership that watches over all industry members.

Once CPOs or CTAs have registered with the CFTC and the NFA, they are subject to several disclosure obligations (see Anson, 2006, for a survey). If a registered entity violates the rules, the NFA has the authority to take disciplinary action, which can range from issuing a warning for small rule violations to ofi cial complaints if rule violations merit prosecution.

Penalties consist of censure, reprimand, expulsion, suspension, ban from future association with any NFA member, and fines up to $250,000 per violation. The NFA also has the authority to reject, suspend, restrict, or place conditions on any firm’s or individual’s registration.

National Futures Association
National Futures Association

Natural Gas

Natural gas is a gaseous fossil fuel. It is mainly used for heating in households and industrial processes, in power generation, and increasingly as raw material for chemical processes (e.g., fertilizer production).

Transportation is either via pipelines or via liquefied natural gas (LNG) ships. Consequently, the delivery of natural gas is defined via hubs, where one or more pipelines or LNG terminals are connected to, for example, Henry-hub in the United States.

Demand for gas is mainly driven by weather, demographics, economic growth, and fuel competition. Additional price influence is given by storage and exports while the supply is mainly determined by pipeline capacity, storage, gas drilling rates, and weather events like hurricanes, technical issues, and imports. Natural gas consumption in the power sector is expected to grow in Europe as the shift from coal to gas is one of the many possibilities to reduce CO2 emissions.

Gas is traded on exchanges, for example, NYMEX or ICE. Contract size at the NYMEX is 10 million British thermal Units (btu) with a tick size of 0.001 USD per 10 million btu leading to a tick size of 10 USD per contract. The daily price limit is 3 USD per 10 million btu. Deliveries start at the first calendar day of the delivery month and end at the last calendar day of the month.

Natural Gas
Natural Gas

Position Trader

A position trader can be defined as one who either buys or sells contracts and holds them at least overnight. Position traders usually hold positions for a few days, weeks, or even for months.

Trading expenses and analysis techniques differ according to trade duration. Position traders are more concerned about long-term trends and believe that they can make a profit by waiting for major market movements.

Fixed costs are slightly low for position traders and they are likely to use long-term technical analysis for evaluating trade opportunities. Position trading is safer than other types of trading, mainly because position traders are not pressed for time and can stay in the trade to earn more or to minimize losses.

Futures trading involves risk and may not be suitable for all types of investors. Several factors such as market conditions and seasonality effects affect the timing of trading. Seasonality is an important factor for position traders to take into consideration.

Since position traders stay in the trade longer, they can better cope with any seasonal variations. Generally, day trading and position trading have a great deal in common. Technical analysis and fundamentals help improve both kinds of trading.

Position Trader
Position Trader

Red Herring

“Red herring” is a preliminary registration submitted to the Securities and Exchange Commission (SEC) by the companies intending public offerings of securities. It outlines the important information about the new issue, including proposed price range and balance sheet and other relevant financial information about the company.

Outside the United States, it is sometimes called the “pathfinder prospectus.” this preliminary prospectus is referred to as a red herring because it contains the following warning, generally in red ink:
The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. this prospectus is not an of er to sell these securities and we are not soliciting any of er to buy these securities in any jurisdiction where the offer or sale is not permitted.
The Securities Act of 1933 makes it illegal in the United States to sell securities to the public without first registering with the SEC. Once the registration statement is filed with SEC, a shorter version of the statement (red herring) is created.

It is a provisional statement that includes all the information about the company apart from the exact offer price and the effective date. Since the registration and marketing process can take several months, providing information on the exact price and effective date is impossible; thus, it generally includes a price range.

Red herring is then sent to potential investors around the country. At this period no written sales literature other than “tombstones ads” and red herring are permitted by SEC. Unlike Europe, in the United States the analyst reports are strictly forbidden before SEC approves the registration.

During the marketing period, investors evaluate the issue. The demand for the offer is estimated and the final issue price is set based on the bids and feedbacks. If this price is not within the preliminary price range in red herring, a revision is made indicating a new price range.

Indeed, since the price range in red herring is prepared prior to getting feedback from potential investors, the i nal price in the United States is ot en outside of the initial price range in the red herring document. Once SEC approves the registration statement, it becomes effective and trading is allowed.

Red Herring
Red Herring

Redemption Period

Hedge funds typically limit subscription and redemption possibilities by specifying the dates at which investors can enter the fund, by determining a minimum investment period, the so-called lockup, and by specifying the terms of redemption. The redemption period determines the frequency with which investors can withdraw money from the hedge fund.

Currently, the most common redemption periods are at the end of a month or at the end of a quarter, although we occasionally see much longer periods (e.g., 1 year), particularly for funds investing in rather illiquid markets or securities. Redemption periods are often combined with redemption notice periods that specify how many days in advance investors have to notify that they wish to redeem.

Typically, the notice period is between 30 and 90 days. In addition, hedge funds may impose further restrictions upon redemption, for example, by limiting the number of shares that can be redeemed at any given date or by imposing penalty fees for early redemption.

Combined, restrictions on redemption limit the possibilities of investors to quickly respond to poor past performance of a hedge fund by withdrawing their money. Occasionally, it can take up to six quarters before a desired redemption can be effective.

Aragon investigates the relation between hedge fund returns and restrictions that limit the liquidity of fund investors. His results suggest that share restrictions allow funds to efficiently manage illiquid assets, and these benefits are captured by investors as an illiquidity premium.

Redemption Period
Redemption Period

Registration Statement

A registration statement is a part of the process of registering securities in the United States. Many other countries follow similar procedures. The registration process is controlled by the Securities Act of 1933, so called because it defines the rules for securities disclosure.

One of the key provisions of the Securities Act is that the sale of securities in a state must comply with the laws and regulations for that state, even if the securities transaction involved interstate commerce.

Note that most of the Securities Act rules do not apply to unregistered securities (including most hedge funds, commodity pools, private equity partnerships, privately placed stock, bonds, and loans, and many real estate investments). Other laws govern commodities, investment management, broker-dealers, and pension plans.

The registration statement is filed with the Securities and Exchange Commission (SEC). This statement contains information about the issue and the issuing company, as a disclosure to potential investors.

The registration is often called a "red herring" because it contains bold sections in red type, reflecting the preliminary nature of the document. This early document is not considered an adequate disclosure to actual investors, so it must contain a disclaimer announcing that it is not a solicitation to sell securities.

Registration Statement
Registration Statement

Regulation D Fund

Regulation D (Reg D) is a U.S. regulation that organizes the limited offer and sale of securities without registration under the Securities Act of 1933. It provides three exemptions from the Securities and Exchange Commission’s (SEC) registration requirements, which allow smaller companies to offer and sell their securities very quickly, at low cost, and with lower disclosure requirements than standard public offerings. Most domestic U.S. hedge funds rely on Reg D to place their securities directly to a selected group of investors.

Furthermore, Reg D offerings provide investment opportunities for hedge funds and thus build a hedge fund strategy. A Reg D fund invests in companies that are raising money using Reg D. This means that these funds are primarily holding illiquid positions in small-capitalized companies.

Depending on whether equity or convertible bonds are issued, investments take one of two forms. In an equity issue, the hedge fund buys the stocks of the offering company at a discount with respect to the current market price. The stocks are not registered on an exchange and the investor has to observe a holding period before the stocks can be sold on the stock market.

During the holding period, the stocks can only be traded among accredited investors, so that there is hardly any liquidity. In a convertible issue, the investors purchase a convertible bond that can be converted into a specific number of shares at a predetermined price.

The Reg D companies often need immediate financing and offer very attractive conditions to investors. The profit the hedge fund manager tries to capture is the discount between the purchase price and the market value of the publicly traded stocks at issue.

Regulation D Fund
Regulation D Fund

Regulation D Offering

The regulatory basis for offering and selling securities is the Securities Act of 1933, including rules (§§ 230.501–230.508) that govern the limited of er and sale of securities without registration. The latter is known as Regulation D. Common securities of Regulation D offerings are equity and convertible bonds.

Besides Regulation D, there are other exempts from registration, such as for the issue of insurance policies and short-term commercial papers or securities issued by governments, nonprofit groups, common carriers, and banks.

According to the Securities Exchange Act of 1934, companies with more than 500 shareholders, $10 million assets, or those listed on national stock exchanges are required to register. An investment strategy based on these issues is also known as Regulation D investment or PIPE investments (private investments in public entities).

Despite its complexity, Regulation D is an easy method of financing for small companies. Rule 501 provides several definitions, which are applied in rules 504, 505, and 506.

According to Rule 501,
  1. accredited investors are typical institutional investors (such as banks, brokers, insurance companies, pension funds, and trusts), private development companies, members of the (top) management of the issuer, and individuals with a net worth of about $1 million or an income of about $200,000 in the two most recent years. 
  2. Companies can be issuers, or in case of reorganization, also the trustee or debtor. 
  3. The calculation of the number of nonaccredited investors is also ruled.

Rule 502 determines general conditions for Regulation D offerings.
  1. The issuer has to inquire whether the purchaser acquires the securities for his own or a third party’s account and the purchaser should not be an underwriter. 
  2. The issuer must notify purchasers that securities are not registered under the Security Act and therefore cannot be resold. 
  3. General solicitation and advertisement are not allowed. 
  4. Just as in registered offerings, documents for nonaccredited investors have to be disclosed. Any information for accredited investors can be made as long as these meet antifraud provisions. All information for accredited investors must be disclosed to nonaccredited investors as well. 
  5. The issuer must be available to answer questions by prospective purchasers. 
  6. For non-accredited investors a certified financial statement must be provided by an independent public accountant (in some cases the company’s balance sheet or the audited financial statements prepared under the federal income tax laws are sufficient).

Rule 503 specii es the filing of notice of sale (505/506). Within 15 days at er the first sale of securities, the issuer has to file Form D to the SEC, which includes names and addresses of the company’s owners and stock promoters. Registration of securities and sending of reports to the SEC are not required.

Three exemptions for limited offerings and sales without registration are named in rules 504, 505, and 506.

Rule 504 exempts offers and sales of securities that do not exceed $1 million in any 12 month period. Before the small business initiatives (August 1992), the general rules 501, 502, and 503 have to be met. Thereafter, under certain conditions there can be a public offering of securities up to $1 million to an unlimited number of investors of any kind, without delivery of disclosure documents.

It is required that the issuer is not a blank check company and does not have to file reports accordingly to the Securities Exchange Act of 1934. In some cases, state security laws may be stricter. Antifraud provisions have to be abided. This means no including or excluding of information that would be false or misleading.

Rule 505 provides the exemption for offers and sales of securities not exceeding $5 million in any 12 month period. An unlimited number of accredited investors and 35 nonaccredited investors are able to buy the offered securities. The definitions (rule 501), the general conditions (rule 502), and the filing of notice of sale (rule 503) have to be met.

Rule 506 provides the exemption for unlimited offers and sales of securities. It is considered as a safe harbor for private offering that arises under Section 4(2) of the Security Act (504 and 505 are small offerings).

An unlimited number of accredited investors and 35 nonaccredited investors are able to buy the offered securities while non-accredited investors have to understand the merits and risks of the investment. Again all definitions (rule 501), general conditions (rule 502), and the filing of notice of sale (rule 503) have to be met.

Compared to full SEC registration, a Regulation D offering has the advantage to be easier, faster, and cheaper. Furthermore the issuer is in safe harbor (legal protection) if all requirements are fulfilled. For small companies, which are fast growing, have large expenses (R&D), or run out of liquidity, Regulation D provides fast new capital.

Under unfavorable market conditions or restructuring, (secondary) public offerings are often not possible for small and unknown companies. In the past, high-tech, Internet, and biotechnology companies used Regulation D intensely. The danger of losing control of the company exists when toxic PIPEs occur.

Toxic PIPE refers to a situation when convertible bonds are issued and the conversion ratio depends on the future equity price. Through short selling of the equity, the purchaser of the convertible bond reduces the equity price and receives more (in some cases the majority) shares.

Investors of Regulation D offerings often receive a discount on the security price due to the restriction on reselling them. Moreover it is possible to invest in growing businesses in early stages. The risks of such an investment are illiquidity, uncertain business model of a small company, and the voluntary nature of information received.

Regulation D Offering
Regulation D Offering

Relative Value Arbitrage

Relative value arbitrage not only defines a single strategy but also the combination of all arbitrage strategies such as merger arbitrage, fixed-income arbitrage (credit spread arbitrage, capital structure arbitrage, yield curve arbitrage, mortgage-backed securities arbitrage), volatility arbitrage, index arbitrage, split strike conversions, statistical arbitrage, stub trading, and convertible arbitrage.

Hedge fund managers pertaining to this strategy group execute spread trades to generate positive returns from relative price discrepancies among securities or financial instruments such as equities, fixed income, convertible bonds, options, subscription rights, and futures while simultaneously avoiding market risks.

Here a spread denotes the deviation of a security from its theoretical/fair value and its historical average or from the economic relation of two correlated securities. Once these temporary price anomalies are identified through statistical or fundamental analysis, the over-valued security is sold and simultaneously the undervalued security is purchased, taking into account the respective hedge ratio.

Upon a closer examination, the investments on the relative price relation between two securities independent from the current capital market condition lead to a minimization of directional bias—hence relative value arbitrage hedge funds are also known as "market neutral" hedge funds.

If at er spread trading, beta or market risk still remains, it can be neutralized through options or futures. However, market neutral must not be confused with no risk, as demonstrated in 1998 with the collapse of the widely known relative value hedge fund Long-Term Capital Management (LTCM).

In the current high technology era the spreads based on the violation of one price are very small and only of short-term existence; thus, hedge fund managers try to leverage their returns up to 100 times the company capital. As a result, the credit risk included rises as well. Relative value arbitrage generates profit as soon as the prices of the traded securities revert to their historical average.

Particularly in extreme market situations based on euphoria or panic, it may take a very long time until the prices based on the efficient market hypotheses are reached again. Conversely, it is possible as well for the price anomalies to widen.

Investigations of the performance of relative value arbitrage indices of important database providers show moderate but stable profits with a low correlation toward equity markets. Considering the return distribution, we nevertheless observe fat downside tails, leptokurtosis, and substantial negative skewness.

Relative Value Arbitrage
Relative Value Arbitrage

Reporting Guidelines

Reporting Guidelines
Reporting Guidelines

Reporting guidelines give private equity funds detailed recommendations about the disclosure of additional information to investors. They aim to homogenize the information for investors, increase transparency, and thus improve trust and confidence between general partners and investors. Two main reporting guidelines have been developed in the past.

For Europe, the European Venture Capital Association (EVCA) first introduced industry-reporting guidelines in March 2000, which were updated in June 2006. EVCA distinguishes between requirements that fund managers have to report if they claim compliance with the guidelines and recommendations that must not necessarily be followed. Semiannual reports are required; quarterly reports are recommended.

For the United States, the Private Equity Industry Guidelines Group (PEIGG) issued reporting and performance measurement guidelines in March 2005, which were developed under the participation of the British Venture Capital Association (BVCA) and EVCA.

PEIGG guidelines require quarterly reporting. Both EVCA and PEIGG industry-reporting guidelines do not address financial statements of private equity funds but intend to promote additional information on fund level, including capital accounts.

Although on fund level, the information requirements of EVCA and PEIGG are quite similar, EVCA guidelines require much more reporting on portfolio company level, for example, location of head office, business description, co-investors. Interestingly, concerning portfolio companies’ balance sheet items, securities ownership and valuation, and other performance metrics, PEIGG guidelines are more precise than EVCA guidelines.

For reasons of completeness, the private equity provisions of the Global Investment Performance Standards (GIPS) issued by the CFA institute in February 2005 should be mentioned, although they focus primarily on fundraising rather than permanent reporting during the fund’s lifetime.

Reverse Leveraged Buyout

Namibia, Africa
Namibia, Africa

A leveraged buyout transaction of a publicly listed firm that is taken private by a later stage private equity fund (buyout fund) is called going private. The phenomenon of an initial public offering (IPO) of a former public firm after some value enhancing years in the portfolio of a later stage private equity fund is called a reverse leveraged buyout (RLBO).

Owing to comparable good data availability, there are some empirical investigations about the long-run performance of U.S. reverse leveraged buyouts in the 1980s. In contrast to the widely documented poor stock prize performance of IPOs and seasoned equity offerings, all authors find no underperformance subsequent to the IPO for reverse leveraged buy-outs.

The results are robust for both market and accounting performance. The results indicate that private equity funds are concerned about the post-IPO performance of their investments since they are repeated players in the IPO market and hold a significant ownership stake in the public firms subsequent to the IPO.

Right of First Refusal

This is a contractual right to enter a business transaction granted by an owner to a potential buyer or investor. The holder of this right is the first party, before anyone else, to be offered the deal, that is, the option of accepting or rejecting a contract with the owner.

Only when the holder turns down the deal is the owner allowed to make the purchase or offer investment opportunity to other potential buyers or investors. For example, a startup company is obliged to offer its investment opportunities first to the venture capitalist that holds the right of first refusal.

If rejected, the company can then shop around for other potential investors. Thus, the holder of the right of first refusal is always the first party to make an of er or a refusal to invest. In addition to being used in private equity, the right of first refusal also applies to many other types of assets such as real estate.

Note that the right of first refusal is distinct from the right of first offer. The latter only requires the owner to engage in exclusive, good faith negotiations with the right holder before turning to other parties while the former is an of er to enter a contract on exact or approximate terms.

Right of First Refusal
Right of First Refusal

Risk Arbitrage

Risk arbitrage is a hedge fund investment strategy that attempts to profit from the arbitrage spread in mergers and acquisition. Thus, this strategy is also often called merger arbitrage. After a merger or an acquisition is announced, the target company’s stock mostly trades at a discount to the price offered by the acquirer.

The reason for this is that there is no guarantee that the merger will be completed. The difference between the offer price and the target’s stock price is the arbitrage spread that risk arbitrageurs try to capture. If the merger is successful, the arbitrageur receives the arbitrage spread. If the merger fails, the arbitrageur incurs a loss.

There are two types of mergers: cash and stock. In a cash merger, the acquiring company offers to purchase the shares of the target company for a certain amount of cash. Afterward, the target’s stocks trade at a discount to the offer price.

In this situation, the risk arbitrageur buys stocks of the target. He gains if the merger is successful and the acquirer buys the stocks. In a stock merger, the acquirer announces a plan to exchange stocks of the target company in own stocks in a certain exchange ratio.

In this situation, the risk arbitrageur buys stocks of the target company and might go short in stocks of the acquiring company. If the merger is successfully completed, the target’s stock are converted into the acquirer’s stocks based on the given exchange ratio and the hedge fund manager again captures the arbitrage spread.

As it is necessary to build up a long position in the target company and (in case of a stock merger) maybe also a short position in the acquiring company, the liquidity of the stocks involved in merger and acquisition is of great importance for a successful risk arbitrage.

In addition, analysis of the legal situation is necessary, because the approval of the responsible regulator is one of the main impediments to many merger and acquisition transactions.

Risk arbitrage is a typical example of an event-driven strategy. It contains elements of many other hedge fund investment strategies, such as relative value, convertible arbitrage, volatility arbitrage, and statistical arbitrage.

Some authors also consider other trading opportunities in the company’s life cycle as forms of risk arbitrage. To these situations belong stock index reconstructions or stock repurchases, which might offer interesting arbitrage opportunities.

Risk Arbitrage
Risk Arbitrage


In the process of an IPO, or seasoned equity or bond issue, the roadshow is the moment when the initiative is presented to an audience of institutional investors; the aim is to draw attention to and excite interest in the security offering that will follow (Benveniste and Spindt, 1989; Schulte and Spencer, 2000).

A roadshow (also known as a "dog and pony show") is made up of a series of meetings in which the intermediary or intermediaries that handle the issue (book-runners) introduce the company’s management team and its development projects and business plan to a more or less limited number of institutional investors, portfolio managers, and financial analysts. The aim is to facilitate placement of the securities and/or increase the liquidity of the shares already traded on the stock market.

Since the roadshow depends on the size of the offering, the type of issuer, the profile of target investors, the pre-chosen market, and last but not the least the actual interest shown in initial meetings, it is not possible to determine either the length of this phase (generally it runs from a few days to a few weeks) or the cost.

The roadshow is important for setting the share price for the IPO, because the intermediaries that follow the company can weigh their opinions against those of the people who will deem the initiative a success or a failure. In other words, intermediaries can come up with an of er price that is more in line with the expectations of the public, as observed during the various meetings


Rogers International Commodities Index (RICI)

The Rogers International Commodity Index (RICI) is a composite, U.S. dollar-based, total return commodity index, created by the investment legend Jim Rogers in 1998. RICI represents the value of a basket of 36 diferent exchange-traded physical commodities consumed in the world economy, spanning from agriculture to energy to metal products, combined with the returns of the 3 month U.S. Treasury bill rate held as collateral.

The selection and weighting of the portfolio is reviewed annually in December by the RICI Committee, which consists of the chairman Jim Rogers and one representative of each party: UBS, Daiwa Securities, Beeland Management, Diapason Commodities Management, and ABN Amro.

Only the chairman can recommend new members for the committee. The selection criteria for futures contracts to be included in the RICI are an important role in global (developed and developing economies) consumption and public tradeability on an exchange to guarantee tracking and verification.

In terms of ensuring liquidity, the most liquid futures contract internationally, in terms of volume and open interest, is chosen for computation of the RICI, if a commodity trades on several exchanges.

To maintain stability and investability, the composition of the RICI is only altered under uncompromising circumstances, such as, nonstop unfavorable trading conditions for a single futures contract or critical changes in international consumption patterns.

The Chicago Mercantile Exchange in collaboration with Merrill Lynch offer TRAKRS (total return asset contracts), which are exchange-traded, nontraditional futures contracts on the RICI.

Rogers International Commodities Index
Rogers International Commodities Index


A roll-up is a consolidation strategy that aims to assemble a leading firm within a certain industry through an amalgamation of acquisitions and natural growth. A roll-up can be in combination with either an initial public offering of stock (sometimes called a "poof IPO") or a high-yield debt offering.

A more common strategy would be the strategic roll-up ("build-up" or "buy and build" strategy), which uses private equity and debt for the initial acquisitions. The strategic roll-up identii es a fragmented industry characterized by relatively small firms.

Buyout firms (e.g., private equity companies), which have industry expertise, purchase a firm as a platform for further acquisitions (add-ons) in the same industry. The goal is to build firms with strong management, develop revenue growth while reducing costs, with the objectives of improved margins, increased cash flows, and increased valuations.

It is vital that the consolidation strategy takes place in industries where acquisitions could be strategically well integrated and where the synergies of consolidation comprise both revenue enhancements and cost savings.

In addition, characteristics of these industries are high fragmentation (i.e., numerous small competitors), a considerable industry revenue base (i.e., multibillion), maturity of industry (moderate-to-slow growth in overall industry revenues), no dominant market leader, and a small number, if any, of national players.

Thus critical mass is attainable with a manageable number of acquisitions and numerous willing sellers with profitable operations. These features generate the opportunity for a well-financed, professionally managed group to rapidly achieve a national presence and a leading role in an industry through acquisitions.


Round Turn

Starting to rain
Starting to rain

The purchase (or sale) of a futures contract commits the buyer (seller) to accept (provide for) the delivery of a commodity or financial instrument in a specified amount of the commodity or financial instrument at a specified time, location, amount, and quality.

If the buyer or seller of the futures contract does not want to take on the obligation of accepting or providing delivery of the underlying commodity or financial instrument, it is necessary to enter into an of setting purchase or sale of the same futures contract.

For example, if one purchased a contract for 1000 barrels of June 2008 crude oil, then one would need to sell a contract for 1000 barrels of June 2008 crude oil prior to the last trading day for this futures contract, as specified by the relevant futures exchange in order to not have to accept or receive delivery of 1000 barrels of crude oil. This purchase and corresponding sale of a futures contract is termed "round turn".

Sample Grade


A sample grade is the quality of a commodity that is too low to be acceptable for delivery in satisfaction of futures contracts. The grade that is acceptable for delivery is called standard grade. First grade or high grade is the opposite of the sample grade. The different grades are defined due to the variations in the quality of commodities. Grain is especially affected by a broad range of these variations.

To guarantee a specific quality, the United States Grain Standards Act defines inter alia the sampling, licensing of inspectors, and inspection requirements for commodities. The Secretary of Agriculture of the United States is authorized to issue regulations under the Act to ensure the efficient execution of the provisions.

Included in the regulations are the Official Grain Standards of the United States. These standards have been developed for wheat, corn, barley, oats, rye, flaxseed, soybeans, etc. They include descriptions for different quality grades including sample grades.

For instance, for corn, U.S. sample grade is corn that does not meet any requirements of the other quality grades, that includes a determined amount of contaminants such as glass, stones, or unknown foreign substances, that has a commercially objectionable foreign odor, or that is otherwise of distinctly low quality. If a commodity is U.S. sample grade, it is not allowed to be delivered.

The grading of a certain commodity is accomplished by licensed inspectors. They are obliged to satisfy criteria set by the Secretary of Agriculture regarding requirements for taking a correct and representative sample and for determining the accurate grade of any commodity.


Plastic Dreams magazine - Models Bruna Tenorio
Plastic Dreams magazine - Models Bruna Tenorio

In futures exchanges, a scalper is considered as a noninstitutional trader who makes a great number of purchases and sales each day. The scalper maintains the resulting positions for only brief intervals of time, and holds either zero or small net overnight positions.

He/she purchases and sells quickly, making either little profit or loss. In general, the scalper is ready to purchase at a lower price than the last transacted price and to sell at a fraction higher, therefore generating market liquidity.

Silber (1984) found that the average scalper holds positions open for approximately 2 min and trades an average of 2.9 contracts per trade. Working (1977) found that a typical scalper holds positions open from 1 to 9 min and trades only one to four contracts at a time.

Scalpers tend to specialize in market making. Collectively, they estimate the function of institutional market makers by making available the required liquidity services. They are seen as providers who match buyers and sellers requiring instantaneous execution of their trades.

In fact, scalpers receive income from hedgers by momentarily taking up hedging orders that are not immediately assimilated. The price of immediacy is, thus, the mechanism by which scalpers derive their profit. Nevertheless, scalpers are under no obligation to continually bid or offer, or to make an orderly market.

Scalpers tend to specialize in scalping particular commodities rather than moving around the floor, and they do little brokering. In fact, they do little speculating outside their home market and infrequently execute trades for other participants in the market.

To summarize, scalpers tend to trade for their own account in their home market in such a fashion as to generate income from the asynchronous order flow from customer accounts.

Seasoned Equity Offering (SEO)

✯ Snow Path
✯ Snow Path

A seasoned equity offering (SEO) is a new issue of an equity security that has previously been placed in the market through a prior issuance. Although an SEO is a primary market transaction, it is not the first time that the security will actually be held by the general investing public; it simply adds to the number of outstanding shares.

Firms, generally, have two options for facilitating an SEO: a cash offer or a rights offer. In a cash offering, the new shares are issued to the public for cash, which results in a reduction of the proportional ownership of existing shareholders (i.e., dilution).

However, with a rights offering, existing shareholders are awarded rights to purchase the new shares, many times at a reduced cost relative to the market value. Existing shareholders can choose to exercise the rights, thereby retaining their proportional ownership, or they can sell the rights in the open market.

Under either approach, issuing firms will typically employ an underwriter, who will serve a similar role as in an initial public offering (IPO)—overseeing legal, administrative, and marketing aspects of the issuance.

Nonetheless, since the security is already traded, there is less pricing risk, which implies the compensation (gross spread) received by the underwriter is much smaller than for an IPO. Further, this reduced pricing risk also results in a much lower degree of underpricing (almost nonexistent) relative to a typical IPO.